QUIC RESEARCH REPORT · 2016-11-17 · QUIC Research Report November 2, 2015 A Stalwart Subsector...
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QUIC RESEARCH REPORT
QUIC Research Reports focus on
emerging investment themes that
affect current portfolio companies
and companies under coverage.
Financial Institutions
Group
An Overview of the North American Banking Space
Banks represent a the largest subsector within the financial institutions
space. Given the subsector’s central role in the most recent financial
crisis, North American banks have been closely followed in recent years
by both regulators and investors. Exposure to interest rates has made
the subsector particularly interesting – and volatile – over the past few
months as the Fed has digressed on the timing and pace of interest rate
increases. Banks account for approximately 56% of QUIC’s synthetic
market cap-weighted S&P 100 Financials Index in the U.S., and
approximately 67% of the S&P/TSX Capped Financials Index in Canada.
North American banks can be separated into following three types:
1. Retail and Commercial Banks
2. Investment Banks
3. Custodial Banks
Return on capital metrics are a major differentiating factor for North
American banks. This is seen through materially different book value
and earnings multiples attributed to firms in the market. Banks with
comparably high return metrics enjoy book value and earnings
multiples far above their peer groups. An example is Wells Fargo,
whose ~12.9% ROCE has driven its book value and earnings multiples
far above its large U.S. bank peers.
An Introduction to North American Banks
A Stalwart Subsector Within the Financials Space
November 2, 2015
Chris Bulla
David Chan
Andre Luk
Neil Shah
Michael Benzinger
QUIC Research Report
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A Stalwart Subsector Within the Financials Space
November 2, 2015
Table of Contents
An Overview of the North American Bank Space 1
Overview of Retail and Commercial Banks 3
Overview of Investment Banks 4
Overview of Custodial Banks 5
Deposit Gathering, Loan Underwriting, and Net-Interest Margin 6
Non-Interest Rate Sensitive Products 7
Overview of Bank Financial Statements 8
Capital and Regulatory Requirements 9
Comparison and US and Canadian Banks 10
How do Interest Rates Affect Banks 11
Profitability and Valuation Methodologies 12
References 17
QUIC Research Report
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A Stalwart Subsector Within the Financials Space
November 2, 2015
Source: Federal Reserve
3
Overview
Banking at it core means accepting deposits from
both retail and commercial sources for the purpose
of underwriting loans or making investments.
Retail banks provide basic banking services to
individuals. Retail banks include savings banks,
savings and loan associations, and recurring and
fixed deposits. Products include, checking and
savings accounts, certificates of deposit (CDs), and
mortgage, personal, and car loans.
Commercial banks provide financial services to
businesses. Products include credit and debit cards,
bank accounts, deposits and loans, and secured and
unsecured loans. Commercial banks also provide a
number of services that compete with investment
banks including money market operations, debt
underwriting, and financial advisory. Commercial
banks can be either public sector or private sector
institutions.
Revenue and Income Drivers
The first driver of revenue and income are interest
rates. Retail and commercial banks generate
revenue and income by raising funds with low-cost
deposits and using those funds to underwrite loans.
The difference between what a bank pays to
depositors and what it earns from its loans is called
the Net Interest Margin (NIM); a larger NIM leads to
higher earning power on underwritten loans.
Market conditions are another driver, particularly
for commercial banks. Fee-based services such as
advisory, debt underwriting, and money market
operations are boosted during positive conditions.
Major Players
The largest U.S. players include Wells Fargo, J.P.
Morgan, Bank of America and Citigroup. The largest
Canadian players include RBC, Toronto Dominion,
Bank of Montreal, Bank of Nova Scotia, and CIBC.
Retail and Commercial Banks
EXHIBIT 2EXHIBIT 1
Commercial Bank Count in U.S. Net Interest Margin for U.S. Banks
Source: Federal Reserve
Steady Decline Over Past 30 years Net Interest Margins Have Significantly Declined
1984 1988 1992 1997 2001 2005 2010 2014
0
2,000
4,000
6,000
8,000
10,000
12,000
14,000
16,000
1984 1988 1992 1997 2001 2005 2010 2014
2.0%
2.5%
3.0%
3.5%
4.0%
4.5%
5.0%
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A Stalwart Subsector Within the Financials Space
November 2, 2015
Source: Thomson Reuters
4
Overview
An investment bank is a financial institution that
provides a number of services for individuals,
corporations and governments. Investment banks
raise capital for clients by underwriting and/or
acting as an agent in the issuance of new securities.
Investment banks advise companies involved in
mergers and acquisitions, both on the buy and sell-
side. They also provide ancillary services such as
market making, and trading of derivatives, equity
securities, fixed income instruments, foreign
exchange, and commodities.
Investment banks also act as a financial advisor for
a wide range of transactions. These activities
include management of public assets, financial
consulting services, and restructuring services.
Many firms used operate proprietary trading desks,
where a firm risks its own capital to invest, but have
since been prohibited due to the Volcker Rule.
Revenue and Income Drivers
The primary revenue and income driver for
investment banks is market condition. Favorable
market conditions lead to much higher volume of
capital raising and mergers and acquisition
transaction activity.
Market volatility is another important driver,
particularly for trading operations, as it leads to
higher level of activity in derivative, equity, fixed
income, foreign exchange, and commodity trading.
Major Players
Major U.S. players include Goldman Sachs, Morgan
Stanley, J.P. Morgan, Bank of America Merrill Lynch,
and Citi. Major Canadian players include RBC
Capital Markets, National Bank Financial, CIBC, TD
Securities, and BMO Capital Markets. Major
European players include Deutsche Bank, Barclays,
Credit Suisse, and UBS.
Investment Banks
EXHIBIT 4EXHIBIT 3
Investment Banking League Table ($M) Industry Fee Market Share by Industry
Source: Thomson Reuters
Increasing Market Share for American Banks Healthcare and Financials Fees Have Dominated
$1,452
$1,597
$2,377
$2,460
$2,686
$3,111
$3,706
$3,901
$4,482
$4,613
UBS
WFC
CS
Barclays
DB
Citi
MS
BofA
JPM
GS
Financials
30%
Healthcare
11%
Energy & Power 10%Industrials
9%
High
Technology
7%
Other
33%
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A Stalwart Subsector Within the Financials Space
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Source: Company Filings and Marcato Research
5
Overview
A custodial bank, also known as a trust bank, is a
financial institution that specializes in protecting an
individual’s or firm’s financial assets. Custodial
banks act as a custodian of non-discretionary trust
assets for customers; they earn a fee for this service.
Custodial banks also offer services in which they
perform most or all of the middle-office and back-
office work relating to holding the assets including
paying taxes, accounting for dividends and interest
payments, and filing regulatory forms. Typical
clients include financial firms, sovereign wealth
funds, and mutual funds. These assets are known as
assets under administration; all investment
decisions are made by the client.
Custodial banks often operate investment funds; a
fee-based service driven by assets under
management (AUM) and performance. AUM are
funds where managers make investment decisions.
Revenue and Income Drivers
The first important driver of revenue and income is
growth in assets under custody. An increase in
custodial assets typically leads to higher servicing
and administration fees. Assets under management
is also a driver, as management and performance
fees are generated based on total AUM.
Interest rates are also a critical revenue and income
driver. Custodial banks earn net interest revenue on
their interest-bearing assets (loans); similarly to
commercial and retail banks, custodial banks earn
the spread between interest paid on deposits and
interest earned on underwritten loans. This spread
is known as the net-interest margin.
Major Players
Major players in the U.S. include the Bank of New
York Mellon, State Street Bank and Trust Company,
J.P. Morgan, Citigroup, and BNP Paribas.
Custodial Banks
EXHIBIT 6EXHIBIT 5
Assets Under Custody Assets Under Administration
Source: Company Filings and Marcato Research
$150 Trillion Global Market $30 Trillion Global Market
BNY
Mellon
19%
State Street
14%
J.P.
Morgan
14%Citi 10%
BNP Paribas
6%
Other
37%
State Street
22%
J.P.
Morgan
22%
BNY Mellon 11%
HSBC
9%
IFDS
6%
Other
30%
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A Stalwart Subsector Within the Financials Space
November 2, 2015
Deposits
Banks collect deposits, make loans, and profit on
the spread between them. In order for a bank to
continually make loans, they must first grow its
deposit base. In order to do this, banks use various
methods, such as promotional interest rates, cash
or item prizes, and discounted account fees.
Deposits can be segmented in three distinct ways –
transactions versus non-transaction, interest-
bearing versus non-interest-bearing, and core
versus non-core. Transaction accounts permit the
account holder to withdraw or transfer payments –
these accounts are as chequing accounts. Non-
transaction accounts have more restrictions in
terms of transferring payments; the most common
types include savings and GICs. Generally speaking,
banks incur higher processing expenses, but lower
interest expenses with transaction accounts. Core
accounts normally refer to deposits made in a
bank’s natural demographic market and are
primarily composed to transaction accounts.
Over the past 25 years, banks have sought to grow
assets faster than deposits and as a result, have
become reliant on borrowings to fund their assets.
Since there are also more investment opportunities
for households, less people have deposited their
capital in banks, as illustrated in the graph below.
Loans
Since loans and leases provide the bulk of a bank’s
revenue via interest revenue, it is by far the largest
asset class on a bank’s balance sheet. Over the past
50 years, banks have shifted their asset mix toward
loans and away from low-risk securities in order to
grow earnings and shareholder returns.
Loans can be segmented by maturity, industry,
security, and type of borrower, but are typically
classified as real estate loans (residential), loans to
individuals (credit card), commercial and industrial
loans (capital expenditure), and other loans
(interbank). Historically speaking, loans to
individuals are the most likely to default, followed
by real estate loans, commercial and industrial
loans, and finally all other loans. As a result, banks
require higher yields on riskier loans, such as credit
card loans.
Although most banks are somewhat diversified in
their loan portfolios, most either have technical
expertise in underwriting certain loan types or are
geographically situated and therefore predisposed
to certain loan types. For example, Bank of America
continues to be the country’s leader in commercial
lending – J.P. Morgan and Wells Fargo round out
the top three commercial lenders.
Residential
Mortgages
25%
Commercial
and Industrial
Loans
23%
Commercial RE
20%
Credit Card
8%
Retail
7%
Other
17%
50%
60%
70%
80%
90%
1990 1994 1998 2002 2006 2010 2014
6
Deposit Gathering and Loan Underwriting
Real Estate Loans Dominate Market
U.S. Commercial Banks: Loans by Type
EXHIBIT 7
Deposits Increasing Since 2008 Financial Crisis
U.S. Commercial Banks: Deposits to Total Assets
EXHIBIT 6
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Although banks receive a large portion of their
revenue from interest income, a business mix
including products and services that are not interest
rate sensitive helps diversify away some risk for the
world’s largest lenders.
Wealth Management
Wealth management is the process of advising and
consulting high net worth individuals on all aspects
of their financial situation by offering services and
products that are best suited for them. Since
revenue is mainly derived from management and
performance fees, wealth management divisions are
protected from a change in interest rate. Many
banks, such as Morgan Stanley, are now focusing
on wealth management as an area of potential
growth as aging populations demand constant
monitoring of their wealth.
Corporate and Investment Banking
Corporate and investment banking includes
advisory to a global client base on their financial
needs, such as equity and debt issuances, mergers
and acquisitions, and restructuring. Revenue is
largely fee-based, but this segment is still
somewhat exposed to interest rates as a high
interest rate environment may discourage
corporations from issuing debt to fund operations.
Asset Management
Asset management is the service of overseeing a
client’s investments by investing on behalf of them
and offering access to a wide range of traditional
and alternative product offerings that would not be
available to an average retail investor. Much like
wealth management, revenue is derived from a
management fee and performance fees, depending
on the ability of the fund manager to outperform
the market. Interest rate movements will not
directly impact revenue, it may increase or decrease
returns and assets under management, which will
directly affect performance and management fees.
Investor and Treasury Services
Investor and treasury service provides specialize in
asset servicing, custody, payments, and treasury
services for financial and institutional investors
worldwide. Select products and services include
fund administration, shareholder services,
compliance monitoring, transaction banking, and
foreign exchange services.
Non-Interest Income
$103.3
$66.6 $69.9$78.7 $76.5 $77.3
$84.6$93.6 $91.6
2007 2008 2009 2010 2011 2012 2013 2014 2015E
Gradual Recovery Since 2008
Global Investment Banking Revenue ($B)
EXHIBIT 8
$33,570 $32,639 $32,346 $32,898 $33,693
$4,430 $4,441 $4,639 $4,549 $4,580
Q2 14 Q3 14 Q4 14 Q1 15 Q2 15
Long-Term Money Market
Slow and Steady Growth
Worldwide Open-End Fund Assets ($T)
EXHIBIT 9
$38,000 $37,080 $36,985 $37,447 $38,273
Source: Reuters
Source: ICI Global
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Balance Sheet
Generally speaking, a bank’s assets are comprised
mostly of loans, securities, and reverse purchase
agreements. Loans usually account for over half a
bank’s assets and although this may sound counter
intuitive, loans are treated like accounts receivable
for banks since it is capital owed to the bank over a
period of time. On the other hand, a bank’s
liabilities can be classified into the following
categories: deposits, repurchase agreements,
derivate instruments, securities sold short, and
other liabilities. The largest liability is deposits,
which on average accounts for 68% of a bank’s
liabilities. Like the concept of loans being assets,
this may seem counterintuitive yet it follows the
same logic, as a deposit is essentially an account
payable for a bank. Since the deposit does not
below to the bank itself, it is capital eventually
owed back to a customer. In an ideal world a banks
deposit to loan ratio would be 1:1 as this would
maximize their ability to generate revenue, however
this ratio is often found to be larger than ideal so
that a margin of safety is created.
Income Statement
In general, a bank’s revenue can be broken down
into two categories. The first, interest income, is the
money received through interest payments on
loans the bank has given out. In 2013, it accounted
for, on average, 49% of revenue for large Canadian
banks. The important factor to consider when
assessing a bank’s interest income is their Net
Interest Margin (NIM). The Net Interest Margin is
the difference between the interest a bank earns
from investing the money from their customer’s
deposits and the interest they are paying the
customer. Although interest income is the primary
source of revenue, it is not the only source. All other
sources of revenue are categorized under non-
interest income, such as wealth management,
investment banking, and credit card fee. In general,
the larger the bank, the larger the percentage of
total revenue non-interest income will make up.
Expenses can be broken up similarly. The first main
expense is Provisions for Credit Losses. This is
essentially an allowance for bad debt expense for
the loans the bank lends out. Some non-interest
expenses include salaries and benefits, technology,
communications, and business development.
Overview of Bank Financial Statements
Net Loans &
Acceptances
54%
Securities
23%
Reverse
Repurchase
Agreements
10%
Other
13%
Deposits
68%
Repurchase
Agreements
7%
Shorted
Securities
6%
Other
13%
Derivatives 6%
Loans Make Up Majority of Banks’ Assets
Canadian Big Six: Asset Breakdown
EXHIBIT 10
Deposits Dominate Banks’ Liabilities
Canadian Big Six: Liability Breakdown
EXHIBIT 11
Source: CIBC World Markets Source: CIBC World Markets
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Global Regulatory Changes Post Financial Crisis
During the recent global financial crisis, a number
of banks became insolvent and either failed or
received taxpayer-funded bailouts.
This crisis resulted in a series of significant
regulatory changes in regards to capital and
liquidity for the international banking sector
designed to prevent this type of global problem
from occurring again.
Introduction to Basel III
In December 2010, the Basel Committee on Banking
Supervision (BCBS) finalized the Basel III package
aimed at:
• Increasing the capacity of banks to absorb losses
relative to risk
• Constraining leverage through a credible, non-
risk-based backstop
• Increasing the capacity of banks to absorb
shocks to funding and constraining structural
funding mismatches
• Incorporating systemic and macroprudential
perspectives into capital framework
• Providing greater transparency so market
participants can make informed assessments of
banks’ potential vulnerabilities to shocks
Basel III Capital Rules & Relation to Canada
There are several categories of rules related to
capital under Basel III. Taken together, these rules
require banks to hold enough capital to equal at
least 10.5% of their total risk-weighted assets by
2019.
To implement this, the Office of the Superintendent
of Financial Institutions (OSFI) issued the final
version of the revised Capital Adequacy
Requirements Guideline. Under the CAR Guideline,
OSFI expects banks to meet target capital levels
that equal or exceed the 2019 Basel III minimum
capital requirements in 2013, well before that 2019
deadline.
Canada’s banks are among the best capitalized
banks in the world in terms of both the quality and
quantity of capital, and have been judged the
soundest in the world by the World Economic
Forum for the last five years.
Basel III Liquidity Rules
The Basel Committee has developed two minimum
rules for liquidity – the Liquidity Coverage Ratio
(LCR) that has a 30-day horizon, and the Net Stable
Funding Ratio (NSFR) that has a time horizon of
one year. These rules are meant to ensure banks
have sufficient, high-quality liquid assets to
withstand a period of economic stress
Stress Testing
Stress testing is a scenario-based analysis designed
to determine the ability of financial institutions’
capital resources to withstand unfavourable
economic conditions.
In the US, the Federal Reserve evaluates financial
institutions’ capital adequacy, internal capital
adequacy assessment processes, and their
individual plans to make capital distributions, such
as dividend payments or stock purchases through
CCAR and DFAST.
Within Canada, the Bank of Canada uses stress
testing through their semi-annual Financial System
Review (FSR). The focus of the FSR is to assess the
main vulnerability and downside risks to the
stability of the Canadian financial system.
Ultimately, These stress test evaluate a bank’s ability
to meet capital and regulatory requirements set out
by The Dodd Frank Act (US) or the Bank of Canada.
9
Capital and Regulatory Requirements
QUIC Research Report
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November 2, 2015
Concentration
One key difference between Canadian and U.S.
banks is the fragmentation within the market. The
Canadian market is dominated by a small number
of large banks, frequently referred to as the Big Five
or Big Six (RBC, TD, Scotiabank, BMO, CIBC and
National). The U.S. market boasts many giants such
as JPMorgan, Wells Fargo, Bank of America,
Citigroup and U.S. Bancorp but thousands of
successful small regional banks have emerged from
historical regulations encouraging the creation of
local banks.
Diversification
On average, Canadian banks tend to be more
diversified than U.S. banks. This is due to the pure-
play nature of many U.S. regional banks. Smaller
U.S. regional banks make up a significant portion of
the U.S. total and tend to focus on traditional loans
and deposits. On the other side, many of the largest
U.S. banks are very well-diversified and resemble
Canadian banks. Common business lines that
diversify earnings and generate non-interest
income include wealth management and capital
markets.
Profitability
The differing levels of profitability between
Canadian and U.S. banks is not as clear as the
contrasting market concentration. On one hand, net
interest margins (NIMs) are significantly larger in
the U.S. The Big Six Canadian banks averaged a
NIM of 1.98% versus an average NIM of 3.14% in
the U.S. This is partially due to a steeper yield curve
in the U.S. than in Canada.
On the other hand, Canadian banks have higher
ROEs than U.S. banks. The average Canadian bank
has an ROE of 16.7% versus 10.3% in the U.S. Other
than greater diversification, one of the reasons why
Canadian banks possess greater ROEs with lower
NIMs is tied to their greater leverage. It is common
for Canadian banks to hold mortgages on their
balance sheets, while in the U.S. it is common for
loans to be securitized and sold. Since mortgages
are seen as low risk, this allows Canadian banks to
boast higher asset balances for the same capital
levels.
This causes Canadian banks to trade at a slight
premium to their U.S. peers
10
Comparison Between Canadian and U.S. Banks
Canadian Banks Offer Greater Profitability at a Greater Valuation
Source: Capital IQ
Canadian versus U.S. Banks
EXHIBIT 12
0.0x
0.5x
1.0x
1.5x
2.0x
2.5x
3.0x
0%
5%
10%
15%
20%
25%
RBC TD BNS BMO CIBC Wells
Fargo
JPM Bank of
America
Citi USB
Return on Equity Price-To-Tangible-Book Ratio
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Borrow Low, Lend High
To summarize bank interest rate exposure, higher
interest rates or a steeper yield curve are seen as a
positive for expanding net interest margins, and
thus profitability.
Comparing Banks to Traditional Businesses
Banks can be understood by comparing them to
traditional consumer retail businesses. A principle of
consumer retail businesses is to buy low and sell
high. The markup between the price bought (Cost
of Goods Sold) and price sold (Revenue per Unit) is
the gross profit earned by the company.
Banks apply a very similar technique to earn profits
– banks borrow low and lend high. For example, a
commercial bank may borrow money from a central
bank at an interest rate of 50bps (or may use a
portion of deposited bank account funds paying
50bps) and may lend the same money to a
customer needing a mortgage at an interest rate of
250bps. The difference between these interest rates
of 200bps is called the net interest spread. Net
interest margins are similar to net interest spreads,
but factor in differing volumes between amount
borrowed and amount loaned. For example, RBC’s
balance sheet currently shows nearly $500 billion in
loans. Given the magnitude of its loan balance, it is
easy to see how a 200bps net interest spread can
translate to roughly $10 billion of annual net
interest income.
Banks require borrowed funds or interest-bearing
deposits to loan out money to earn interest income.
Given that banks need leverage to operate, and that
borrowed funds can be compared to the “Cost of
Goods Sold” of a loan, this is one reason why banks
cannot be valued in an unlevered state such as a
discounted cash flow. Any income metric that does
not take into account interest income and interest
expense such as EBITDA or UFCF has no meaning.
Yield Curve
The core business model of a bank is to use
deposited funds or borrow short-term funds to
make long-term loans. For example, banks borrow
overnight from the central bank to loan for a 10-
year mortgage. In other words, banks borrow (pay
interest expense) at the low end of the yield curve
and lend (receive interest income) at the high end
of the yield curve. Based on this information, it can
be seen that a steepening of the yield curve will
increase net interest margins. A flattening of the
yield curve would have the opposite effect,
reducing net interest margins. The steeper the yield
curve, the greater a bank’s profitability.
Yield Spreads of Different Duration Act as a
Rough Proxy for the Steepness of the Yield Curve
The size of yield spreads between a short-term and
a long-term interest rate can be a rough indicator
for the steepness of the yield curve. For example,
the 3M5Y spread shows the income spread earned
by borrowing at 3-month rate and lending at the 5-
year rate. If the yield curve is steep between the
short-term 3-month rate and the medium-term 5-
year rate, the yield spread will be large. The larger
the yield spread, the more profitable it is for a bank
to make loans.
11
How Do Interest Rates Affect Banks?
Short-Term Yields Remain Extremely Low
Source: U.S. Department of the Treasury
U.S. Yield Curve
EXHIBIT 13
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
3.0%
3.5%
1mo 3mo 6mo 1yr 2yr 3yr 5yr 7yr 10yr 20yr 30yr
Lend High (Long-Term)
Net In
tere
st Sp
read
Borrow Low (Short-Term)
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Profitability and Valuation Methodologies
The major portion of bank’s profit comes from the
fees that it charges for its services and the interest
that it earns on its asset. The traditional measures
of profitability of any business are its ROA and ROE.
However, a bank’s net interest margin is the most
looked at metric when evaluating a bank’s
profitability. Net interest margin shows how well
the bank is earning income on its assets. A high net
interest income and margin indicates a well
managed bank and also indicates future
profitability.
In terms of valuation methodologies, due to the
significance of interest to a banks’ operations,
analyst must stray away from the DCF analysis. The
three valuation methodologies available are the
Sum-of-the-Parts Model, Dividend Discount Model
(DDM) and Residual Income Model.
EXHIBIT 8
Source: Thomson One, Capital IQ
Sum-of-the-Parts Valuation Method
Wells Fargo & Co
Sum-of-the-Parts Valuation
Business Operations Comps
(In USD Millions) 2014A 2015E 2016E P / E 2014A 2015E 2016E
Community Banking 14,180 12,433 14,401 10.9x 153,971 135,002 156,368
Wholesale Banking 7,584 7,541 8,141 18.7x 141,865 141,063 152,289
Wealth, Brokerage, and Retirement 2,083 1,699 1,926 13.9x 28,912 23,586 26,726
Intercompany Eliminations -790 0 0 0.0x 0 0 0
Implied Equity Value from Business Operations 324,748 299,650 335,384
Segmented Earnings Implied Equity Value
Value Attributable to Equity 2016E Current Price $55.05
Using median comparables 335,384.0 Price Target $63.00
Fully Diluted Shares Outstanding 5,323.4
Per Share Value from Business Operations $63.00 Target Return 12.62%
Implied Valuation
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Profitability and Valuation Methodologies
EXHIBIT 9
Source: Thomson One, Capital IQ
Dividend Discount Model and Residual Income Valuation Method
Residual Income Assumptions
Mid-Year Convention: 0.50
Minimum Tier 1 Common Ratio: 12.0%
Annual Stock Repurchases: 5,000$
Return on Common Equity:
Development: 16.0%
Maturity: 16.0%
Long-Term: 16.0%
Risk-Weighted Assets Growth:
Development: 7.0%
Maturity: 7.0%
Cost of Equity: 11.49%
Present Value of Equity Calculations:
Current Value of Common Equity: 165,708$
Sum of PV of Residual Income: 32,109
Terminal NI Growth Rate: 3.0%
Estimated Year 6 NI to Common: 34,868
Residual Income Terminal Value: 115,951
PV of Res. Inc. Terminal Value: 71,088
Present Value of Equity: 268,904$
Diluted Shares: 5,323.4
Implied Share Price: 50.51$
Implied Return -8.98%
DDM Assumptions: Exit Multiple Method
Mid-Year Convention: 0.50
Minimum Tier 1 Common Ratio: 12.00%
Return on Tangible Common Equity 14.00%
Risk-Weighted Assets Growth: 3.00%
Cost of Equity: 11.49%
Terminal Value:
Sum of PV of Dividends: 73,940
Terminal P / TBV: 1.50 x
Terminal Value (Multiple): 313,807
PV of Terminal Value: 182,211
PV of Terminal Value as % of Total PV 71.13%
Present Value of Equity: 256,151$
Diluted Shares: 5,323.4
Implied Share Price: 48.12$
Implied Return -12.59%
Discount Rate Calculation - Assumptions
10-Year US Treasury (Risk-Free Rate): 2.21%
Equity Risk Premium: 5.39%
Comparable Companies - Levered Beta Calculation
Equity Levered
Name Value Beta
Citigroup Inc. 160,120$ 1.38
JP Morgan Chase & Co. 241,080$ 1.22
Bank of America Corporation 177,890$ 0.85
U.S. Bancorp 75,420$ 0.86
Median 169,005$ 1.04
Wells Fargo & Company 160,111$ 1.72
Cost of Equity Based on Comparables: 7.82%
Cost of Equity Based on Historical Beta: 11.49%
QUIC Research Report
November 2, 2015
A Stalwart Subsector Within the Financials Space
November 2, 2015 14
Appendix (SOTP)Community Banking
(In USD Millions) 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E 10A-14A 15E-19E
Revenues
Net Interest Income 31,885 29,580 29,045 28,839 29,709 31,194 32,442 33,415 34,418 35,450 (1.8%) 3.2%
Annual % Growth (8.4%) (7.2%) (1.8%) (0.7%) 3.0% 5.0% 4.0% 3.0% 3.0% 3.0%
Non-Interest Income 22,604 21,124 24,360 21,500 21,153 21,788 22,441 22,890 23,348 23,815 (1.6%) 2.2%
Annual % Growth (11.9%) (6.5%) 15.3% (11.7%) (1.6%) 3.0% 3.0% 2.0% 2.0% 2.0%
Total Revenue 54,489 50,704 53,405 50,339 50,862 52,982 54,883 56,306 57,766 59,265
Expenses
Provision for Credit Losses (Reversals) 13,807 8,001 6,835 2,755 1,681 6,239 5,840 5,681 5,507 5,318
As % of Net Interest Income 43.3% 27.0% 23.5% 9.6% 5.7% 20.0% 18.0% 17.0% 16.0% 15.0% 21.8% 17.2%
Non-Interest Expense 30,071 29,234 30,840 28,723 28,126 28,324 28,052 27,468 28,017 28,578
As % of Non-Interest Income 133.0% 138.4% 126.6% 133.6% 133.0% 130.0% 125.0% 120.0% 120.0% 120.0% 132.9% 123.0%
Total Expenses 43,878 37,235 37,675 31,478 29,807 34,563 33,891 33,149 33,524 33,895
Earnings Before Tax 10,611 13,469 15,730 18,861 21,055 18,419 20,992 23,157 24,242 25,370
As % of Total Revenue 19.5% 26.6% 29.5% 37.5% 41.4% 34.8% 38.2% 41.1% 42.0% 42.8% 30.9% 39.8%
Income Tax 3,347 4,072 4,774 5,799 6,350 5,526 6,088 6,484 6,788 7,104
As % of Earnings Before Tax 31.5% 30.2% 30.3% 30.7% 30.2% 30.0% 29.0% 28.0% 28.0% 28.0% 30.6% 28.6%
Net Income From Non-Controlling Interest 274 317 464 330 525 460 504 533 533 533
As % of Earnings Before Tax 2.6% 2.4% 2.9% 1.7% 2.5% 2.5% 2.4% 2.3% 2.2% 2.1% 2.4% 2.3%
Net Income 6,990 9,080 10,492 12,732 14,180 12,433 14,401 16,140 16,921 17,734
As % of Total Revenue 12.8% 17.9% 19.6% 25.3% 27.9% 23.5% 26.2% 28.7% 29.3% 29.9% 20.7% 27.5%
Wholesale Banking
(In USD Millions) 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E 10A-14A 15E-19E
Revenues
Net Interest Income 11,474 11,714 12,648 12,298 11,955 12,553 13,055 13,447 13,850 14,265 1.0% 3.2%
Annual % Growth 12.2% 2.1% 8.0% (2.8%) (2.8%) 5.0% 4.0% 3.0% 3.0% 3.0%
Non-Interest Income 10,951 9,952 11,444 11,766 11,527 11,873 12,229 12,596 12,848 13,105 1.3% 2.5%
Annual % Growth 5.2% (9.1%) 15.0% 2.8% (2.0%) 3.0% 3.0% 3.0% 2.0% 2.0%
Total Revenue 22,425 21,666 24,092 24,064 23,482 24,426 25,284 26,042 26,698 27,370
Expenses
Provision for Credit Losses (Reversals) 1,920 (109) 286 (445) (266) 314 313 309 305 300
As % of Net Interest Income 16.7% (0.9%) 2.3% (3.6%) (2.2%) 2.5% 2.4% 2.3% 2.2% 2.1% 2.4% 2.3%
Non-Interest Expense 11,269 11,194 12,082 12,378 12,975 12,823 12,963 13,100 13,105 13,105
As % of Non-Interest Income 102.9% 112.5% 105.6% 105.2% 112.6% 108.0% 106.0% 104.0% 102.0% 100.0% 107.7% 104.0%
Total Expenses 13,189 11,085 12,368 11,933 12,709 13,136 13,276 13,409 13,409 13,404
Earnings Before Tax 9,236 10,581 11,724 12,131 10,773 11,289 12,008 12,633 13,288 13,966
As % of Total Revenue 41.2% 48.8% 48.7% 50.4% 45.9% 46.2% 47.5% 48.5% 49.8% 51.0% 47.0% 48.6%
Income Tax 3,315 3,525 3,943 3,984 3,165 3,725 3,842 3,916 3,986 4,190
As % of Earnings Before Tax 35.9% 33.3% 33.6% 32.8% 29.4% 33.0% 32.0% 31.0% 30.0% 30.0% 33.0% 31.2%
Net Income From Non-Controlling Interest 20 19 7 14 24 23 24 25 27 28
As % of Earnings Before Tax 0.2% 0.2% 0.1% 0.1% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2%
Net Income 5,901 7,037 7,774 8,133 7,584 7,541 8,141 8,692 9,275 9,748
As % of Total Revenue 26.3% 32.5% 32.3% 33.8% 32.3% 30.9% 32.2% 33.4% 34.7% 35.6% 31.4% 33.4%
Wealth, Brokerage, and Retirement
(In USD Millions) 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E 10A-14A 15E-19E
Revenues
Net Interest Income 2,707 2,855 2,768 2,888 3,179 3,338 3,471 3,576 3,683 3,793 4.1% 3.2%
Annual % Growth 12.5% 5.5% (3.0%) 4.3% 10.1% 5.0% 4.0% 3.0% 3.0% 3.0%
Non-Interest Income 9,023 9,333 9,392 10,315 11,039 11,370 11,711 11,946 12,184 12,428 5.2% 2.2%
Annual % Growth 8.0% 3.4% 0.6% 9.8% 7.0% 3.0% 3.0% 2.0% 2.0% 2.0%
Total Revenue 11,730 12,188 12,160 13,203 14,218 14,708 15,183 15,521 15,867 16,221
Expenses
Provision for Credit Losses (Reversals) 334 170 125 (16) (50) 134 122 107 110 114
As % of Net Interest Income 12.3% 6.0% 4.5% (0.6%) (1.6%) 4.0% 3.5% 3.0% 3.0% 3.0% 4.1% 3.3%
Non-Interest Expense 9,768 9,935 9,893 10,455 10,907 11,825 11,946 11,946 12,184 12,428
As % of Non-Interest Income 108.3% 106.5% 105.3% 101.4% 98.8% 104.0% 102.0% 100.0% 100.0% 100.0% 104.0% 101.2%
Total Expenses 10,102 10,105 10,018 10,439 10,857 11,958 12,067 12,053 12,295 12,542
Earnings Before Tax 1,628 2,083 2,142 2,764 3,361 2,750 3,116 3,468 3,572 3,680
As % of Total Revenue 13.9% 17.1% 17.6% 20.9% 23.6% 18.7% 20.5% 22.3% 22.5% 22.7% 18.6% 21.4%
Income Tax 616 789 814 1,050 1,276 1,045 1,184 1,318 1,358 1,398
As % of Earnings Before Tax 37.8% 37.9% 38.0% 38.0% 38.0% 38.0% 38.0% 38.0% 38.0% 38.0% 37.9% 38.0%
Net Income From Non-Controlling Interest 7 6 - 2 2 5 6 7 7 7
As % of Earnings Before Tax 0.4% 0.3% - 0.1% 0.1% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2%
Net Income 1,005 1,288 1,328 1,712 2,083 1,699 1,926 2,143 2,208 2,274
As % of Total Revenue 8.6% 10.6% 10.9% 13.0% 14.7% 11.6% 12.7% 13.8% 13.9% 14.0% 11.5% 13.2%
Intercompany Eliminations
(In USD Millions) 2010 2011 2012 2013 2014 2015E 2016E 2017E 2018E 2019E 10A-14A 15E-19E
Revenue (1,309) (1,386) (3,571) (3,826) (4,215) - - - - - 34.0% -
Annual % Growth 19.0% 5.9% 157.6% 7.1% 10.2% (100.0%) - - - -
Provision for Credit Losses (Reversals) (308) (163) (29) 15 30 - - - - -
As % of Revenue 23.5% 11.8% 0.8% (0.4%) (0.7%) 7.0% 7.0% 7.0% 7.0% 7.0% 7.0% 7.0%
Net Income (Loss) (1,534) (1,536) (697) (699) (790) - - - - -
As % of Revenue 117.2% 110.8% 19.5% 18.3% 18.7% 100.0% 100.0% 100.0% 100.0% 100.0% 56.9% 100.0%
Projection Period CAGR/Average
Projection Period CAGR/Average
Projection Period CAGR/Average
Projection Period CAGR/Average
QUIC Research Report
November 2, 2015
A Stalwart Subsector Within the Financials Space
November 2, 2015 15
Appendix (Dividend Discount Model)
Wells Fargo & Company Dividend Discount Model
($ in Millions Except Per Share Data)
Historical Projected
2014 2015 2016 2017 2018 2019
Normalized Net Income to Common: 21,821$ 25,361$ 26,430$ 28,280$ 30,260$ 32,378$
% Growth: 16.2% 4.2% 7.0% 7.0% 7.0%
Common Dividends: 7,100 23,890 16,038 17,167 18,371 19,658
% Growth: 236.5% (32.9%) 7.0% 7.0% 7.0%
Payout Ratio: 32.5% 94.2% 60.7% 60.7% 60.7% 60.7%
Beginning Common Equity: 153,875$ 165,708$ 167,984$ 179,240$ 191,279$ 204,155$
Plus: Net Income to Common: 21,821 25,361 26,430 28,280 30,260 32,378
Plus: Stock Issuances: - - - - - -
Plus: Stock-Based Comp.: 1,912 1,969 2,028 2,089 2,152 2,217
Less: Stock Repurchases: (4,800) (1,164) (1,164) (1,164) (1,164) (1,164)
Less: Common Dividends: (7,100) (23,890) (16,038) (17,167) (18,371) (19,658)
Ending Common Equity: 165,708$ 167,984$ 179,240$ 191,279$ 204,155$ 217,928$
Avg. Risk-Weighted Assets: 1,243,000 1,330,010 1,423,111 1,522,728 1,629,319 1,743,372
% Growth: 7.0% 7.0% 7.0% 7.0% 7.0%
Tier 1 Common Ratio: 12.5% 12.0% 12.0% 12.0% 12.0% 12.0%
Return on Tangible Common Equity: 16.9% 16.0% 16.0% 16.0% 16.0% 16.0%
Tangible Common Equity / Tier 1 Common Capital Calculation:
Ending Common Equity: 165,708$ 167,984$ 179,240$ 191,279$ 204,155$ 217,928$
Less: Disallowed Intangibles: (26,300) (26,563) (26,829) (27,097) (27,368) (27,642)
Plus: Other Adjustments: 18,000 18,180 18,362 18,545 18,731 18,918
Total Tier 1 Common Capital: 157,408$ 159,601$ 170,773$ 182,727$ 195,518$ 209,205$
Discount Period: 0.0 1.0 2.0 3.0 4.0 5.0
Mid-Year Discount Period: 0.5 1.5 2.5 3.5 4.5
PV of Dividends: 22,626$ 13,625$ 13,081$ 12,557$ 12,052$
Terminal Multiple Sensitivity
Cost of Equity
48.12$ 8.5% 9.5% 10.5% 11.5% 12.5% 13.5% 14.5%
2.1 x $69.68 $66.92 $64.30 $61.81 $59.45 $57.20 $55.07
1.9 x $64.45 $61.92 $59.52 $57.25 $55.08 $53.03 $51.08
1.7 x $59.22 $56.93 $54.75 $52.68 $50.72 $48.85 $47.08
1.5 x $53.99 $51.93 $49.97 $48.12 $46.35 $44.68 $43.08
1.3 x $48.76 $46.93 $45.20 $43.55 $41.99 $40.50 $39.09
1.1 x $43.53 $41.94 $40.43 $38.99 $37.63 $36.33 $35.09
0.9 x $38.30 $36.94 $35.65 $34.43 $33.26 $32.15 $31.10
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QUIC Research Report
November 2, 2015
A Stalwart Subsector Within the Financials Space
November 2, 2015 16
Appendix (Residual Income Valuation)
Wells Fargo & Company Residual Income Model
($ in Millions Except Per Share Data)
Historical Projected
December 31, 2014 2015E 2016E 2017E 2018E 2019E
Normalized Net Income to Common: 21,821$ 26,695$ 27,778$ 29,642$ 31,635$ 33,767$
% Growth: 22.3% 4.1% 6.7% 6.7% 6.7%
Common Dividends: 7,100 25,225 17,386 18,528 19,746 21,047
% Growth: 255.3% (31.1%) 6.6% 6.6% 6.6%
Payout Ratio: 32.5% 94.5% 62.6% 62.5% 62.4% 62.3%
Beginning Common Equity: 153,875$ 165,708$ 167,984$ 179,240$ 191,279$ 204,155$
Plus: Net Income to Common: 21,821 26,695 27,778 29,642 31,635 33,767
Plus: Stock Issuances: - - - - - -
Plus: Stock-Based Comp.: 1,912 1,969 2,028 2,089 2,152 2,217
Plus: Exchange Rate Effect: - - - - - -
Less: Stock Repurchases: (4,800) (1,164) (1,164) (1,164) (1,164) (1,164)
Less: Common Dividends: (7,100) (25,225) (17,386) (18,528) (19,746) (21,047)
Ending Common Equity: 165,708$ 167,984$ 179,240$ 191,279$ 204,155$ 217,928$
Avg. Risk-Weighted Assets: 1,243,000 1,330,010 1,423,111 1,522,728 1,629,319 1,743,372
% Growth: 0.0% 7.0% 7.0% 7.0% 7.0% 7.0%
Tier 1 Common Ratio: 12.5% 12.0% 12.0% 12.0% 12.0% 12.0%
Return on Common Equity: 16.9% 16.0% 16.0% 16.0% 16.0% 16.0%
Tier 1 Common Capital Calculation:
Ending Common Equity: 165,708$ 167,984$ 179,240$ 191,279$ 204,155$ 217,928$
Less: Disallowed Intangibles: (26,300) (26,563) (26,829) (27,097) (27,368) (27,642)
Plus: Other Adjustments: 18,000 18,180 18,362 18,545 18,731 18,918
Total Tier 1 Common Capital: 157,408$ 159,601$ 170,773$ 182,727$ 195,518$ 209,205$
Residual Income / Excess Returns: 7,533$ 7,838$ 8,364$ 8,926$ 9,528$
Discount Period: 0.0 1.0 2.0 3.0 4.0 5.0
Mid-Year Discount Period: 0.5 1.5 2.5 3.5 4.5
PV of Residual Income: 7,134$ 6,659$ 6,373$ 6,101$ 5,841$
QUIC Research Report
November 2, 2015
A Stalwart Subsector Within the Financials Space
November 2, 2015
References
17
1. Bloomberg
2. Capital IQ
3. CIBC World Markets
4. Company Reports
5. Federal Reserve
6. ICI Global
7. Marcato Research
8. RBC Capital Markets
9. Reuters
10. U.S. Department of the Treasury